Friday, June 25, 2010

Winners and Losers from the Yuan Re-valuation


China cleverly announced its decision to permit its currency, the yuan, to float more widely and gradually move higher against the dollar shortly before the G-7 and G-20 meetings. It took away the biggest gripe other nations had about it, and leveraged its ability to lecture them about their failings. The Chinese, who are heavily invested in both dollar and Euro denominated assets, have much to say about the profligacy of the West, and much to gain if Western nations get their financial houses in order. The re-valuation was begun just as China is turning to building domestic consumer demand in order to lessen its dependence on exports to the West. It's no accident Chinese authorities didn't interfere when workers at Honda and Toyota plants in China went on strike. Higher wages in China will boost domestic demand. (Henry Ford did something similar in 1914 when he first began paying workers the then astonishing wage of $5 a day.)

China in the long term will win from the re-valuation of the yuan. Its manufacturers will seek to become more efficient and cost effective in order to preserve their export markets. Given China's indisputable prowess in manufacturing, expect many of them to succeed. The same thing happened with Japan. In the early 1970s, the yen traded at over 300 to the dollar. Despite various Japanese government measures to keep the yen down, it rose to the low 200s per dollar by the end of the 1970s. But Japan kept running a trade surplus with the U.S. because its manufacturers continued to improve (and in some cases move their factories to lower cost countries in Asia, but this still helped Japan maintain a surplus with America). In the 1980s, the yen stubbornly remained around the low 200s until a 1985 international agreement called the Plaza Accord led to its devaluation into the low 100s. Nevertheless, Japan's trade surplus with the U.S. remained sizable. It remains sizable to this day (over $44 billion in 2009), even though the yen now trades around 90 to the dollar. Japan's exporters still work hard to improve efficiency and quality. The Chinese will do the same, and their likely success will preserve many export markets. Efficiency improvements will also help them to seize market share in China's growing domestic markets, reducing opportunities for America and other nations to export to China.

Mexico and other low cost manufacturers will also win. America's now chastened consumers, who have rediscovered the virtues of saving, will resist higher prices. As China's prices rise, American retailers will seek out alternative inexpensive sources of supply. These will almost always be in other foreign nations with low labor costs.

Currency traders at big banks, hedge funds and elsewhere will have more opportunities with a more flexible yuan. Traders like volatility, because price movements, whether they are up or down, create larger profit opportunities than stable exchange rates. Big banks will also profit from selling derivatives products to hedge or speculate in the value of the yuan.


The United States could easily end up on the short end of the stick. A higher yuan will improve American industry's ability to export to China. But long term success is far from certain, as Chinese manufacturers will fight back by vigorously improving their capabilities. America's failure to achieve a trade balance with Japan after the yen more than tripled in value over 30 years is sobering. America needs to concentrate its resources on developing products and services other wealthy nations want to buy. Its last couple of decades of growth have been financed by foreigners purchasing American debt, and that's a trend that won't last. A big recent American innovation, social networking sites, may be fun, and popular overseas as well as here. But these sites are not noticeably profitable, and won't add much to our national income. Investment in basic research and development, bio tech and high tech should be favored. We don't need more financial engineering. We need more science-based engineering. Long term economic growth can't rest on the hoped-for continued escalation of real estate or any other asset. It should come from making things other people want to buy.

EU nations are also likely losers. The still unfolding sovereign debt crisis reveals that Western Europe, like America, used debt instead of productive capability to foster "prosperity." Europe is less innovative than America, and its prospects for growth are correspondingly lower. (EU per capita income is already about 30% lower than America's and Europeans should worry about whether or not that comparison will worsen.) As the rising yuan strengthens China, and American industry seeks to riposte, Europe will be caught in the cross-fire. Germany, with its famed discipline, might maintain relative parity. But the rest of Europe may have to rely increasingly on the quaintness of its tourist sites to pay the bills.

Political Winners

While we've been focusing on economics, the yuan re-valuation eases tensions between America and China, and makes it easier for them to work together on common problems. China wants to become wealthier and stronger. But it would not want America to become weaker. America is the world's police officer, and is taking the brunt of the load of dealing with international nut cases like North Korea's Communist government and the radicals in power in Iran. If the U.S. were to weaken and reduce its level of engagement in Asia, China would be stuck with a lot of nasty problems. The Chinese benefit economically from a prosperous South Korea, so they'd have the primary burden of constraining the loonies in Pyongyang, a job now largely performed by the U.S. troops on the 38th parallel. The Chinese would also have to greatly increase their involvement in the Middle East, a crucial source of petroleum for them and many of their Asian trading partners. The U.S., at great cost in lives and money, currently ensures a steady outflow of oil from the Middle East. And the U.S. war against Islamic radicalism in Afghanistan and elsewhere suits China's purposes. The same radicalism has seeped into the Muslim populations of Chinese Central Asia, creating unrest and occasional violence. The Chinese know they would become a primary target if America withdrew from the field of fire. America, in turn, needs China's cooperation with its many problems in Asia and elsewhere. Thus, both nations are political winners from the yuan re-valuation.

Wednesday, June 23, 2010

How the Fed and the Feds Are Becoming Irrelevant

Today's announcement by the Federal Reserve that it wasn't changing its zero to 0.25% target for the fed funds rate exemplifies the Fed's increasing irrelevance. It had no other choice. And, by all indications, it won't have any other choice for many months and maybe more than a year.

The Fed couldn't have raised rates. Even though doing so would have signaled growing confidence in the economic recovery and a revival of vigilance against inflation, a rate increase might well have dampened already modest economic growth.

But the Fed also can't lower rates. Although negative interest rates aren't literally impossible (a bank that charges fees on a checking account in excess of any interest it pays is imposing a negative interest rate), negative interest rates on a systemic level would erode the banking system as beleaguered savers horde pieces of green (and now sometimes brown) paper. In theory, the Fed could renew some of the asset buying programs it deployed at the height of the 2008 credit crisis (like buying mortgage-backed securities and even U.S. Treasury debt). But doing so would be tantamount to admitting that the sky is indeed falling. Programs meant to relieve a credit crunch might produce one.

Thus, the Fed is backed into a corner with very little room to move. It won't own up to its dilemma, since confidence in the central bank is the principal component of confidence in the banking system. It can only hope to use talk therapy to keep investors, depositors, and consumers from heading for the hills with water purifiers and freeze dried food.

The federal government can't be of much help. While there remains some stimulus money to be spent this and later years, the pipeline is shutting down. Populist politics is forestalling further stimulus legislation, even bills to extend unemployment compensation and federal assistance to the laid off to maintain health insurance under COBRA. These latter measures help America's working population--folks who in most cases will return to the work force sooner or later and whose productivity is essential to the future. Whatever the relative merits of compassion for wealthy bankers versus a helping hand for the middle class, it makes economic sense to prevent the worst consequences of unemployment from befalling those whose productivity is important for the future. Nevertheless, the politics of the hour may preclude even these modest measures. The populist backlash is making the federal government largely irrelevant to combating a likely economic slowdown.

The government's policy choices contributed greatly to the quagmire. The banking system's hundreds of billions of dollars of hinky assets weren't fully excised one way or another but instead were to a large degree papered over when Congress forced an easing of accounting standards. Tumors don't go away by themselves, and banks now horde cash instead of lending it, to protect themselves against losses from their continued large holdings of doggy assets. The financial system was saved from collapse, but it is now doing precious little to help the real economy recover.

European government spending is slowing down, and China will take its sweet time re-valuing the yuan. When you look around, there isn't any obvious impetus for a strong recovery. While you shouldn't panic yet, it might not be a bad idea to quietly look into water purifiers and freeze dried food.

Monday, June 21, 2010

What If the Economy is a Creature?

What if the economy is a creature? What if the financial system is a critter, perhaps a type of varmint? What do we do then?

The doyennes of economic orthodoxy hold that the economy can be understood and explained by identifying fixed relationships between a number of variables. To legitimize their field as science, and themselves as experts, they prefer that these relationships be susceptible to mathematical expression. They secure for their research vast amounts of computer power, and hunt endlessly for reliable data. (The latter is by far the harder to get.) Statistical analysis and robust results well-buttressed by high confidence levels engender the belief that economists might actually know something. Peer review by others equally enamored of tidy regression analyses validate the assumptions made and the banishment of data points deemed outliers in the pursuit of statistically significant confidence levels. The seeming clarity of the results is comforting, not only to professional economists, but also government officials, legislators and the general public.

Then how could economists have missed the real estate and credit bubbles so badly? How could they have misunderstood the tech stock bubble of the late 1990s? What if the baseline assumption of economics--that there are fixed relationships between and among relevant variables that can be uncovered and mathematicized--is wrong? The economy and financial system proved to be a lot less predictable than the doyennes expected. The only thing that is clear is that economists, as a profession, know a lot less than they, and many of the rest of us, believed.

Perhaps the economy, being the combined interaction of large numbers of organic beings (i.e., people), is itself organic. Instead of a constant set of fixed relationships, it may consist of a swirling vortex of dynamically changing interactions that never precisely repeat themselves. People change and adjust the ways they live as the world around them changes. The Boomer generation learned to read and write with paper and pencil, and did its high school research using printed encyclopedias. Yet in a few decades, it has transitioned from Gutenberg's technology to Bill Gates' and Steve Jobs' technology. Information is much more readily available and relationships between people have changed as e-mail, social networking, and more have rendered distance irrelevant and downtime (i.e., time for yourself) a thing of the past.

Isn't it possible, and indeed probable, that the economy has similarly changed? The Phillips Curve, a supposed inverse relationship between inflation and unemployment, was once deemed by economists to be virtually engraved in stone. And for a short period of time, it appeared that way. But after leisure suits ceased to be fashionable, the Phillips Curve became increasingly more difficult to discern in the real world. Conventional economic thought holds that the Phillips Curve was too simplistic. Maybe the truth is that it once had explanatory power but the economy mutated away from it.

Similarly, the gold standard of monetary policy, the lowering of interest rates to stimulate economic activity, seems to have had limited efficacy in recent times. Perhaps changes in and the greatly increased complexity of the financial system has undermined the efficacy of monetary policy. A salient feature of the financial system of the 1990s and the early 2000s was the shadow banking system created with mortgage-backed and other asset-backed securities. A large portion of the economy's credit flowed through this unregulated market. The regulated banks and brokerage firms turned away from extending credit to earning fee income and speculating in proprietary trading. They became less significant as conduits of credit. The shadow banking system collapsed with the financial crisis of 2007-08, and has largely not been replaced. Thus, lowering interest rates has had limited stimulative efficacy because the true conduits for credit have to a large degree ceased to exist.

A visitor from Mars, unburdened by the dogma of conventional economics, would conclude that the economy and financial system aren't driven by fixed relationships, but are dynamic processes whose only constancy is change. The economy, simply put, is a creature that is always changing and evolving. The financial system, infused with Wall Street's voracious appetite for ever-new, high-margin financial engineering, mutates even more rapidly than the economy as a whole, and can sometimes be a nasty varmint if not handled properly.

The notion that the economy is a creature would be disquieting to many economists, as it would cast them into the tar pits of behavioral economics and other potentially mushy bodies of thought. But human relationships and human interactions are mushy. Indeed, they often are blobs. Understanding the economy and the financial system is a never-ending, sometimes Sisyphean struggle to discern changes in economic relationships and interactions. Risk managers in financial institutions and financial regulators have to understand that creative destruction doesn't simply apply to businesses and industries. It also applies to asset classes and the very relationships and processes of the economy and financial system. The Flash Crash wouldn't have happened a few years ago. But it's happened now and can happen again. Monitoring risk, and especially systemic risk, requires knowing not only what's going on, but what's changing and what's likely to change and how. Government officials might have to delve deep into the financial engineering of the big banks and the major trading firms, even as it's evolving and notwithstanding the protests of influential executives about proprietary secrets and preserving competitive advantages.

The Federal Reserve appears likely, under the financial regulatory reform now moving toward enactment, to end up with the greatest share of the responsibility for monitoring systemic risk. Thus, it will have the greatest responsibility for casting aside doctrine and diving into the unknown. Most significantly, regulators may have to apply an element of judgment even when statistically significant analyses aren't easily obtained. Problems can't always be avoided simply because they can't readily be quantified. Regulatory agencies are given, by law, a measure of discretion and they should bring common sense, as well as statistical technique, to bear. That won't be easy, as the Fed's governors and staff sometimes seem more inclined toward stalwartly manning the Maginot Line of economic orthodoxy than anticipating a blitzkrieg through the Ardennes. But financial panics and crises are like the flu virus, constantly mutating and appearing in unexpected forms that existing preventive measures weren't meant to address. Recognizing the organic nature of the economy and financial system, and reacting quickly, before all desired information is available, may well be crucial to ensuring that the financial crisis of 2007-08 and other painful disruptions don't happen again.

Tuesday, June 15, 2010

Will Wall Street Go Democrat?

Wall Street political contributions are going more to Republicans today than Democrats. That's hardly surprising, considering the bashing the big banks have taken from the Obama administration and the inevitability of greater regulation. This trend, however, may not last. Wall Street has strong reasons to go Democrat in the fall.

The Republican Party has been ambushed by Tea Partiers and is making a hard right turn. Only in California, it would seem, could a billionaire moderate Republican, Meg Whitman, survive a Tea Party onslaught--and that required spending tens of millions of her own dollars. The distinctly populist tone forced on the Republicans will compel them to keep Wall Street at arms length, while clamoring for sharp cutbacks in the deficit spending that may be the primary reason the economy keeps growing. In other words, the Republican policies of "No" and "Hell No" could push the stock market down.

The Obama administration and some Congressional Democrats, however, still see the virtue of big federal budgets. The latest measure is a relief package for overly leveraged states and muncipalities. Some members of Congress, with the administration's support, are maneuvering to extend unemployment benefits and health insurance subsidies for the unemployed. Although not necessarily destined for passage, these measures will if enacted help prop up the economy and the stock market. Of course, the Dems have taken up the populist mantel as well. Financial services regulatory reform is almost a certainty this summer, and BP, which should consider more often taking its point of aim off its own feet, makes an easy target for an administration that needs someone to castigate. But Democratic fiscal proclivities may better serve Wall Street's needs than bug-eyed bashing from blame-casting Tea Partiers.

The Dow Jones Industrial Average jumped 213 points today, on a mix of mostly positive, but some negative, news. A lot of the jump seems due to technically driven trading by market pros. Mom and Pop in Sioux City are still sitting on the sidelines. The market pros and the rest of Wall Street need the big budgets of the Democrats to keep today's liquidity fueled stock market propped up, lest the leverage implosion in Europe and wackos in Iran and North Korea unleash bears. The fall campaigns won't begin in earnest until after Labor Day. At that point, the increasingly populist rhetoric from the right may well lead ever pragmatic Wall Streeters to apply some of their trading strategies to politics and hedge their bets with generous contributions to the Dems.

Sunday, June 13, 2010

China's Take on Gold

Late last week, China's central bank announced that it would not buy gold as part of its asset allocation strategies. It cited the gold market's small size, illiquidity and volatility as reasons.

This decision should serve as a warning to gold bugs. The Chinese have issued currencies (first metal and then paper) for thousands of years. They also possess the accumulated wisdom and experience of a civilization that continually existed those thousands of years. China suffered from inflation and financial speculation before Columbus, the Vikings, or whoever discovered America. They know a bag of . . . well, can of worms when they see one.

China has an enormous investment problem. It probably holds more of the world's financial assets than any other single investor, and is engaged in a uniquely difficult search for value. American financial advisers and money managers look for and promise (morally, if not legally, speaking) positive gains, perhaps a tacit reflection of America's singular success in growing geographically and economically during its short existence. The Chinese understand from long experience that, at times, survival is the priority and positive returns may require more risk than is prudent. They largely avoid stocks, and mostly stick with government bonds and other high quality fixed income investments. They didn't abandon the dollar when it sank in relation to other currencies, and haven't abandoned the Euro even though it's sunk in relation to other currencies. They aren't trying to avoid all losses, but seek stability until they can re-focus their economy toward growth based on domestic consumption.

Why would they be uninterested in gold, even though Chinese emperors first coined gold thousands of years ago? Their announced reasons tell the story. Gold can't serve the needs of large-scale modern investment. There isn't enough of it. Most of the value in today's world economy is embodied in securities (like stocks and bonds), bank accounts and other cash equivalents, real estate, and private ownership of businesses. Gold is a fringe investment, whose aficionados sometimes include members of one lunatic fringe or another. It can skyrocket in value, and just as easily nosedive.

Some central banks have increased their holdings of gold in the last few years. But China's decision to avoid investing in the gold market takes a potentially huge buyer out of the picture. Buy gold if you like. Just remember that your sharing the gold market with some semi- or fully whacked out people, and anything can happen. Gold tends to rise in price during times of stress; hence its popularity in recent years. But it won't hold its value after the crisis passes. That was the case in the early 1980s. Your holdings of gold will attain lasting value only if civilization collapses. Give our regards to the Mad Hatter if you think that's going to happen.

Thursday, June 10, 2010

Death of a Golden Goose

Where do Wall Street's mega-profits come from? With free lunches still a myth, it stands to reason those truckloads of dollars have to come from somewhere and someone. With the market wobbly and regulatory reform in the headlines, the question is more important than ever. Especially the question of who the chumps may be.

In this era of bank bailout bonanzas, we know that taxpayers rank high among the chumps. They saved the banking system, and bankers took home the beef--and the lobster, shrimp cocktail, caviar, champagne, and cognac. As middle class taxpayers struggle to keep up with the costs of subsidizing Wall Street, the banks' lobbying blitzkrieg rampages through the halls of Congress in a fairly successful effort to prevent meaningful regulatory reform. For the mostly wealthy people running the financial system, it is apparently better to receive than give.

Customers are a prominent source of Wall Street's profits. The big banks' lobbying scrum in Congress to combat transparency in the derivatives markets aims to protect outsized markups and markdowns that customers can't see. If they can't see these expenses, they can't negotiate very well. Even though customers in the derivatives markets are institutions, they for the most part trade with investor money, like pension contributions, 401(k) contributions, and so on. Markups, markdowns and other transaction costs they incur ultimately come out of investor pockets in the form of lower returns. If derivatives customers are business corporations, then those costs come out of the pockets of shareholders or the customers of the business corporations (in the form of higher prices). As we noted, there still ain't no such thing as a free lunch.

Even in relatively transparent securities markets, such as the mutual fund market, the investor is sold the Brooklyn Bridge. Counterintuitively, mutual fund fees tend to rise the larger funds become. This is true for both stock funds and bond funds. Things were supposed work the other way around. We were told that larger funds would use economies of scale to reduce fees and pass more gains onto investors. However, the mutual fund industry also seems to believe that receiving is better than giving. There are a few exceptions, often in the cases of index funds. But most money managers appear to have captured the benefits of economies of scale for themselves.

The outsized profits of big banks in recent recession years and the increase in mutual fund fees even as funds get larger imply that the relatively high level of concentration in the securities industry is another reason for bankers' big pay days. Businesses love monopolies and oligopolies, and fight governmental efforts to curtail concentration. Some of the biggest lobbying fights in the financial reform arena have been aimed at suppressing measures that would require the big banks to split up, and lose some of their market power. On the other hand, a measure that would protect big banks, concentrating regulatory power in the Fed (which sees size as a regulatory advantage, and which has a long history of brushing aside the interests of retail customers) has pretty much become a certainty. If you don't like Microsoft, you won't like the big banks (and the Fed) because oligopoly in the financial services industry appears to be in our future.

Even do-it-yourself individual investors who frugally stick to index funds and the lowest cost online brokers pay part of the price. They add liquidity to the market and make it easier for the big firms to trade and sell stock and ETF offerings. But what returns do these investors get? The Dow Jones Industrial Average is trading at 1999 levels, if you look at its numerical value. Factor inflation into the picture and the time machine takes you back to 1997, when Monica wasn't a name associated with Presidential scandal. A passbook savings account would have been more profitable.

When an industry imitates the Sheriff of Nottingham, counting 12 for itself and 1 for the poor (which by this count would be just about everyone else), it can only expect ire, taxation and regulation. But potentially far worse would be the loss of customers. The recent bull market was notable for the absence of individual investors. Indeed, one of the quirks of the recent downturn is that it wasn't preceded by a rush of Mom and Pop investors jumping in at the top. Mom and Pop, now the tired, drawn Ma and Pa of Grant Wood's American Gothic, have smartened up about playing on a freeway filled with tractor-trailers driven by overpaid bankers. They're sticking to the farm and to simple investments. Something complex and unpredictable like stocks (and there's no arguing after the Flash Crash that the stock market has become more mysterious and unpredictable over the years, not less so) is left for gamblers and naive dreamers.

Individual investors have been the golden goose for the stock market. Through mutual fund investments and direct stock purchases, they are a major source of savings, the true capital of Wall Street. Without managed money to play with, the big firms could hardly make a fraction of the profits they enjoy. Individual investors are less well informed, and thus easier marks. Many of them hold investments for long periods of time, providing stability while Wall Streeters trade in and out in frantic and often unsuccessful efforts to beat the S&P 500. Without these vasts herds of retail sheep to shear, the big firms would only have each other to snipe at. That would be tough going and far less profitable.

Of course, enormous amounts of capital are invested in stocks because of financial plans already in place. Much (but certainly not all) 401(k) money will stream into stocks. But Wall Street ultimately needs big growth for its big pay days. And the growth goose may not fly again for a generation or more.

Tuesday, June 8, 2010

Bernie's Burdens

New York magazine reports that Bernie Madoff, when hassled about his Ponzi scheme by a fellow inmate at the federal medium security prison in Butner, NC, said, "F*ck my victims. I carried them for twenty years, and now I'm doing 150 years."

Poor Bernie. Life can be truly unfair. Perhaps he can take comfort from being the inspiration for millions of blogs, none of them complimentary. He's our inspiration today. The following is entirely fictional.

The young man was glad to escape the viscous humidity of summertime North Carolina as he entered the visitor's room at the prison. Perspiration dampened even the back of his hands. But when he spotted the man he had come to see, he forgot his discomfort. Business, as always, came first.

"Mr. Madoff?" he asked.

"Yes, I'm Bernie Madoff," said the older, gray-haired man.

"Alvin Doe," said the young man, as the two men shook hands. He tried to project the cheerfulness he had learned people beyond college age expected when first meeting someone.

Bernie wondered if that was the name on the young fellow's birth certificate. He was generic: about 5' 10", medium brown hair, brown eyes and a face you could readily forget. His clothes were also generic--a white polo shirt and khaki slacks. But his precociously jaunty manner seemed out of place for a guy who couldn't be more than a year or two out of college.

"Alvin, it's nice to meet you," said Bernie.

"Here are the things I promised," said Doe, handing three small glass jars over to Bernie.

"The real stuff?" Bernie asked.

"Russian caviar. Cost me more than the plane ticket down here. I asked my Mom to buy it because she would make sure it wasn't fake."

"Well, if your Mom says it's real, that's good enough for me," said Bernie, turning on his salesman's affability and unwinding his impenetrable half-smile. "So, what's on your mind, Alvin?"

"Mr. Madoff, I got an idea . . . an idea for a business. I wanted to talk to you about it."

"Glad to listen, Alvin. My time is yours."

"I was thinking that there's a tremendous opportunity for a business that provides people with excuses," said Doe.

"Excuses?" asked Bernie, genuinely puzzled.

"Look at today's world," continued Doe. "Everyone wants an excuse. No one wants to take responsibility for anything. A business that can supply excuses would be an instant hit."

"Hmm, you have a point there," said Bernie, warming to the idea.

"One of the biggest needs is excuses for financial screwups. There's an almost unlimited pool of customers. We have millions of defaulting homeowners. The ones who strategically default would make especially good prospects. Then there are banks that took bailouts and then made huge profits while the taxpayers who bailed them out struggle with unemployment and falling home values. The banks have armies of lawyers and lobbyists, but their image is terrible. They need the services of a business like mine. Also, there are entire countries over in Europe that borrowed a lot more than they should have and covered it up. But the truth has come out, and they're circling the drain. They don't want to actually take responsibility for all their debts. So they need help talking their way out of trouble. I think there's a lot of money to be made."

Bernie's brow wrinkled. "What you say is true, Alvin. But how do I fit into the picture?"

"Mr. Madoff, you're the champ when it comes to excuses. I mean, you went on for decades and got billions of dollars, all just with good sounding excuses. You didn't need anything else--no real business, no real trading strategy. You made a fortune for yourself out of talk. You have more talent for making excuses than anyone in history. I want you to join my business."

Bernie took a deep breath, while looking over Alvin Doe closely. He could be a junior federal agent, assigned to entrap Bernie in a criminal scheme. But he didn't look like he was wearing a wire under his polo shirt. And why would the feds bother? Bernie was 71 years old and sentenced to 150 years. He couldn't be punished more than he already had been. Doe had the eager enthusiasm of a young guy who saw goals more than he saw obstacles. That was the kind of fellow who would probably succeed.

"Well, Alvin, I might be interested," said Bernie. "How would things work? Since I'm here in prison, I can't put in days at the office. The prison people monitor my phone calls and we can't have computers or Internet access."

"We don't need any of that stuff," said Doe. "I or someone working for me will visit you and talk about the problems clients have. We don't need a lot of paper and we don't need to be connected online. I mean, all we're doing is coming up with excuses. You help us create excuses for the clients when we meet with you. That's all. No need for paper, no need for computers."

"That could work," conceded Bernie. "But what's the split on the money? Fifty-fifty?"

"I was thinking I should get three-quarters and you get one-quarter," said Doe. "I'll be out lining up clients and doing all the administrative work. And I have to handle communications with them and you."

"Don't I have the brainpower, the shamelessness that you can't find anywhere else?"

"Yes, you do, Mr. Madoff . . . "

"Bernie. Call me Bernie."

"Okay, Bernie. You do have the brainpower. But I can't exactly advertise that I'm partnering with a criminal, if you know what I mean. People won't think they're getting a legitimate excuse if it comes from a con artist."

Bernie paused, and then continued. "I think I understand that point, Alvin. Let's say I'll agree to 75 for you, 25 for me, at least to start with. Now, it seems to me that I should get a $1,000,000 advance on profits."

Doe sat back, momentarily stunned into silence. "Are you kidding?"

"Not at all. This is business. Money talks."

"I haven't got a million. I haven't even got air fare. I had to borrow it from my Mom."

"Tell you what, Alvin, I'll settle for $100,000 paid in advance."

"Bernie, I don't have $100,000. I barely have $100, and I have to cover the car rental and crappy airline food. Besides, you can't keep that kind of money, not here."

"There are places where it can go. We can get into that when you find the money," said Bernie.

"That's impossible, Bernie. I can't come up with a hundred grand. Can't you just help me out and take a split of the profits once we start making some money?"

"Well, Alvin, a man doesn't work for free. And a smart man doesn't work for just a promise. Take my word for it. I'll start out for $10,000."

"Well," said Doe, reluctantly rising to leave. "That won't be easy. I'll see what I can do."

"I think you have a great idea, Alvin, with a huge market. People, banks, governments, nobody wants to take responsibility any more. Everyone wants an excuse. Palming off an excuse is much easier than doing real work. Hell, if we took responsibility for things, we'd all have to stop acting like kids and become adults. No one wants to do that. So keep at it, Alvin."

"Okay, Bernie," said Doe, smiling broadly for the first time and extending his hand again.

"That's a nice smile you have, Alvin. Good for sales presentations," said Bernie. "Chin up. The world may be going to hell, but there's always opportunity in adversity. Making excuses will be a great business because you can count on people to pay for what they want to hear. That's what the real estate bubble market was all about. That's what Wall Street is all about. That's what politics are all about. You'll have a great business while it lasts."

The two men parted with a warm handshake. It wasn't until later, after Alvin had boarded his flight home, that he wondered if Bernie's last words meant he should rethink things.

Sunday, June 6, 2010

Is America Becoming Japan?

In the way of generals fighting the last war, the Federal Reserve and Treasury Department have resolutely printed and borrowed money in an effort to avoid another Depression. They may have succeeded, although as with all historical questions we won't know until after the fact. Economic growth has resumed. But we're not out of the woods, as last week's data reminded us. Employment growth, aside from temporary federal hiring for the census survey, has slowed to a trickle. Retail sales growth was disappointing. China is trying to throttle back its overheated real estate market. Hungary revealed its sovereign debt problems, adding a little fillip to the stew with a comment, subsequently withdrawn, about the possibility of restructuring. The BP oil spill, a dark, scythe-wielding, spectral presence, continued its death march into bayous, bays, and beaches, grinding down the economies of several states. We're at the beginning of the end of federal stimulus spending. With populism all the rage, this pipeline will run dry after currently authorized spending is completed. The Dow Jones Industrial Average is close to its low for the year.

The data suggests that the U.S. is at risk of the kind of stagnation that has bedeviled Japan since its stock market and real estate bubbles burst in 1989-90. Consumers are tight-fisted, banks won't lend, government deficits soar, and the economy grows fitfully at best. That describes Japan for the last two decades and it's starting to sound like America. With unemployment stubbornly high and the America's best export market, the Euro zone, seemingly turning into a nosedive, the prospects for future growth are guarded.

Tightness of bank credit to the real economy remains a central problem. Many smaller businesses have few borrowing options aside from banks. But banks large and small are haunted by bad real estate loans from the bubble years. They've kept these toxic assets inconspicuous, courtesy of a bank friendly, Congressionally coerced relaxation of accounting rules last year. But the continued flaccidity of the real estate market means that the toxic waste will have to be written down eventually, either when it's finally sold or when economic reality overwhelms overly chipper accounting rationalizations. The anticipation of those writedowns leads banks to hold their cash dear. Small businesses evoke thin, ragged Oliver Twist, begging for more porridge.

American banks seem to evoke Japan's zombie banks, which were insolvent but kept on life support by the Japanese government in order to maintain bad loans to failing businesses. America's banks might or might not be insolvent (the answer may differ when one applies economic reality as opposed to accepted accounting rules). They may be, in effect, funding bad loans by not foreclosing on many homes, which remain residences of defaulting borrowers. They hold piles of toxic real estate derivatives and wobbly commercial real estate loans. Now, they need to scrutinize the European portions of their portfolios and perhaps patronize the increasingly expensive credit default swap market for European obligations.

Despite massive government deficit spending and a zero interest rate policy, Japan's economy went nowhere for ten years after its credit crisis and then grew slowly if at all. The U.S. government, too, has relied on deficit spending and a zero interest rate policy. Few other ideas for economic revival seem to be on its agenda. Absent a sea change, it's hard to see how the U.S. economy won't sail into becalmed waters.

Tuesday, June 1, 2010

European Disunion

Today's Wall Street Journal reports that Germany and the European Central Bank are at odds over the ECB's open market bond purchases. The Germans haven't liked this program since the moment it was announced, believing it to transgress the ECB's most fundamental anti-inflation mandate. Now, the Journal reports that German officials have questioned the ECB's purchases of 25 billion Euros worth of Greek bonds. Greece already relies on bailout funds to finance its debt, rather than the secondary market, and German officials evidently reason that the ECB wouldn't need to intervene in the secondary market that Greece can no longer access. However, such purchases would bail out European banks holding Greek debt. The Journal reports that French banks are the largest holders of Greek debt.

Jean-Claude Trichet, the President of the ECB, is sometimes rumored to be considering a challenge to Nicholas Sarkozy for the Presidency of France. If so, it would hardly hurt his prospects to act visibly to protect French banks. Of course, some of the money that might have been used to buy Greek bonds from French banks comes from Germany. All the better from the French perspective, but the Germans might take a different point of view, especially if the bond purchase program could advance the ambitions of a French politician they don't like.

The May 10, 2010 trillion dollar Euro bloc bailout package changed the bloc fundamentally. What was once a group of nations joined together to share the economic benefits of a common, stable currency transformed itself into a fiscal union. The wealthier Euro bloc nations are tightening their belts to protect and subsidize the poorer members. But the new "union," created in the ad hoc crisis atmosphere of a bond vigilante ambush, is voluntary. It requires, above all, the unwavering commitment of the two largest members, Germany and France. If these two heavyweights begin sparring with each other, disunion will follow. The fact that the ECB has been reticent about the details of the bond purchase program would only fuel German suspicions. Germany no doubt feels it has already been caught by surprise too many times in the sovereign debt crisis.

Enormously powerful market forces press on the Euro and the Euro bloc's sovereign debt. The May 10, 2010 Euro bloc bailout package is a slender seawall, and if it cracks even slightly, the bloc could dissolve. If the ECB were using, in part, German funds to bail out French banks holding Greek debt, that would only illustrate a fortiori why the Euro bloc can't succeed. There are no controls, there is no supervision. Accountability always comes after the fact, when the damage has been done. In a sense, many Germans now feel that they are subject to taxation without representation. Americans understand that feeling, and know where it can lead.